A Guide To Profitability Ratios

The most commonly used profitability ratios are:
  • Operating profit margin.
  • Gross profit margin.
  • EBITDA margin.
  • Net profit margin.
  • Cash flow margin.
  • Return on equity.
  • Return on assets.
  • Return on invested capital.

The Three Most Important Profitability Ratios

Types of profitability ratios

You can use a variety of profitability ratios to learn more about the health and performance of your company’s finances. Each ratio belongs to one of these two categories:

Margin ratios

At different cost levels and measurement levels, a company’s ability to convert sales into profits is indicated by its margin ratios. Operating profit margin, net profit margin, gross profit margin, cash flow margin, EBIT, overhead ratio, and operating expense ratio are a few examples of margin ratios.

Return ratios

The return a company can provide to its shareholders is represented by return ratios. Return on assets, return on retained earnings, return on revenue, return on equity, return on cash assets, return on debt, risk-adjusted return, and return on capital employed are a few examples of return ratios.

Businesses use a variety of profitability ratios to evaluate productivity by comparing income to assets, equity, and sales. The most commonly used profitability ratios are:

Businesses can examine their earnings before taxes and investment-related interest costs by looking at their operating profit margin. High operating profit margin businesses are able to settle debt, shareholders, and other financial commitments. Additionally, they stand a better chance of surviving economic fluctuations and providing lower prices than their rivals who enjoy lower profit margins.

Gross profit margin measures gross profit to sales revenue. A company’s gross profit is determined by deducting sales from cost of goods sold and dividing the result by gross profit. Rent, utilities, and employee salaries will be deducted from a company’s total profit.

Before any non-operating expenses are deducted, a company’s profitability is shown by its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) ratio. Items like interest, taxes, depreciation, and amortization are non-operating costs that are not taken into account. Because it displays a company’s profitability prior to financial and accounting deductions, EBITDA is frequently used in place of net income earnings and provides a more accurate measure of corporate performance.

A company’s net profit margin paints a complete picture of its profitability. Businesses can determine their net profit margin by dividing their net income by their total revenue. This ratio accounts for all expenses a company incurs, including interest and taxes. Due to the metric’s inclusion of one-time costs and gains that don’t follow a pattern every fiscal year, the historical financial value cannot be compared to those of other businesses.

The relationship between a company’s sales and operating cash flow is known as the cash flow margin. This ratio measures how a company converts sales into cash. Companies can have more money available to pay dividends, suppliers, service debt, and utilities when their cash flow is high. Even though a company is making money or having sales, they still lose money if their cash flow margin is negative. If their cash flow is insufficient, businesses may decide to borrow money or raise capital from investors to keep going.

Return on equity (ROE) is the percentage of a company’s net income that corresponds to the rate of return on a stockholder’s equity. Stock analysts and investors may pay close attention to a company’s ROE to assess whether it is an efficient operator or one that consistently generates profits. In general, high ROE ratios are a good reason to buy a company’s stock. Companies with high ROE ratios are better able to generate cash internally and rely less on debt financing.

Return on assets (ROA) is the ratio of net income to total assets for a business. ROA reveals the amount of profit an organization makes following taxes for each dollar of assets it owns. This ratio also measures how asset-intense a company is. Businesses with a high asset intensity need to make significant investments in equipment or machinery to be profitable. The manufacturing of cars and the provision of telecommunications services are asset-intensive industries. Less asset-intensive industries are software companies and advertising industries.

This ratio, also known as ROIC, represents the metrics produced by each capital provider, such as bondholders and shareholders. Similar to ROE, but with a broader focus, ROIC includes things like returns on capital provided by bondholders.

What are profitability ratios?

The ability of a company to generate income or profits in relation to its revenue, operating costs, balance sheet assets, and shareholders equity over a given time period is assessed and measured using a set of financial metrics called profitability ratios. These ratios show how effectively a business utilizes its resources to produce profits and value for its shareholders.

Higher ratios show that a company is operating successfully by producing cash flow, revenues, and profits. When a company’s profitability ratios are evaluated against its competitors or previous fiscal periods, they become more significant.

Examples of profitability ratios

Profitability ratios can be used in a variety of ways in business to assess any margin or return that your company may have or provide to shareholders and bondholders. You can use the following examples to better understand specific profitability ratios:

EBITDA example

Wintergreen retail company makes $200 million in revenue, but incurs production costs of $80 million and operating costs of $25 million. Depreciation and amortization total $15 million, resulting in an operating profit of $80 million. $5 million in interest costs is equal to $75 million in earnings before taxes. After subtracting $15 million in taxes at a 20% tax rate, net income equals $60 million. EBITDA equals $95 million if amortization, depreciation, interest, and taxes are subtracted from net income.

Net income $60,000,000
Depreciation Amortization +$15,000,000
Interest expense +$5,000,000
Taxes +$15,000,000
EBITDA= $95,000,000

Gross profit margin example

By creating apps, New Company generates $30 million in revenue and spends $12 million on costs for goods and services. New Companys profit will be $30 million minus $12 million. Businesses can determine the gross margin by dividing the $18 million gross profit by the $30 million total, which equals 0. 60 or 60%. Thus, the gross margin profit for New Company is 60 cents for every dollar.

The basic formula for calculating gross profit margin is:

Return on equity example

Diamond Bank Corporation reported a net income of $14 billion and shareholders equity of $58 for the third quarter of the fiscal year. 17 billion. Their ratio can be calculated using this basic formula:

Diamond Bank Corporation outperformed the industry average ROE of 20% if the standard ROE for the banking industry was 20%. This indicates that for every dollar DBC made, their shareholders made 24 cents in profit.

FAQ

What are the 5 profitability ratios?

Remember, there are only 5 main ratios that you must be measuring:
  • Gross profit margin.
  • Operating profit margin.
  • Net profit margin.
  • Return on assets.
  • Return on equity.

What are the 4 profitability ratios?

Profitability ratios assess a company’s ability to turn a profit in relation to its sales, operating costs, assets, and shareholder equity. This means that these ratios show how effectively a business uses its assets to produce profitability and add value for shareholders.

What are the six profitability ratios?

Six fundamental ratios are frequently used to choose stocks for investment portfolios. These include the debt-to-equity ratio, return on equity (ROE), price-earnings (P/E), working capital ratio, quick ratio, and earnings per share (EPS).

How do you determine profitability ratios?

You can assess the relationship between the profits your business makes and the assets that are being used by using the return on assets ratio. You calculate it using information from the balance sheet and the income statement. (Multiplying by 100 converts the ratio into a percentage. ).

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